Market Contraction and Innovation Divergence: The Impact of the US–China Trade War on Chinese Innovation

Abstract: This paper studies the impact of the US import tariff on the intensity and direction of innovation in China during the trade-war period. Empirically, we break down patent abstracts into technical terms through textual analysis, enabling a comparison of innovation directions between Chinese and US firms based on the similarity of these terms. We document that greater exposure to US import tariffs reduces the similarity, particularly with more recent US patents, while patent filings in China also decline in response to higher US tariffs. To interpret these patterns, we develop a heterogeneous firm model in which firms endogenously allocate innovation efforts across product features (mapped to technical terms in patent abstracts) and make export decisions. In the model, tariff shocks affect innovation through changing export demand. We quantitatively find that this demand channel explains 27% of the decline in China–US innovation similarity following tariff shocks. Furthermore, changes in innovation intensity and direction lead to a 3.5% reduction in Chinese firms’ exports by 2021, with shifts in innovation direction alone accounting for 14% of this reduction.